The Rare 'Buy Stocks!' Signal That Ain't

Time was, stocks were riskier than bonds and should have the higher yield.
But then came inflation...

AT THE START of this week, stocks on the Dow Jones, Tokyo Nikkei and
FTSE100 in London offered a bigger dividend-yield than you'd earn in interest
from their local government bonds.

"That's pretty rare, and in general has been quite a good indicator of turning
points in the markets," notes the Financial Times' investment editor James
Mackintosh. But it only looks rare if you ignore most of history. And it's
only screamed "Buy!" once on Wall Street, back in winter/spring
2009.

Yes, this "signal" worked, notching up a 100% strike-rate for the last fifty
years. But buying stocks today because their yield (only just) beats bonds
might prove ill-timed if not a disaster.

For at least 75 years prior to the late-1950s, US stocks consistently paid
more than 10-year Treasurys. Rather than being an eight-decade-long buy signal,
however, "That was the relationship ordained by Heaven," as the late Peter
Bernstein learnt from his senior partners on Wall Street.

"Because stocks were riskier than bonds and should have the higher yield."

On a monthly basis in fact (paceRobert
Shiller's data), US equity yields offered investors 1.78 percentage points
above Treasury yields between 1871 and 1957, with this "div-yield premium" rising
from a long-term average of 1.30% to 3.02% as the Great Depression morphed
into WWII and equities got riskier still.

Only twice did equity yields fall below bond yields - first in March-May 1872
and then again in July-Sept. 1929. That anomaly first marked the start of a
five-year bear market, and then of the Great Crash itself. Here was a sell
signal even Ken
Fisher could see.

No, it wasn't infallible. Like the inverted yield curve forecasting recessions,
near-zero Div-Yield Premiums forecast three bear markets that failed to show
(Jan. 1890, mid-1899 and spring 1905). And picking the peak in Div-Yield Premiums
was a tough buy signal to follow, as the variance in our fourth column shows.

But for 60 years, every significant top and bottom in US stocks was indeed
marked by a relative extreme in the Div-Yield premium, at least until
the signal broke down - and stocks kept paying ever-more over bonds - in the
Great Depression.

So what of 2010's return to pre-Buddy Holly conditions? No idea, to be honest.
Not with the UK's long Bank Holiday weekend beckoning. But we might get a quick
clue from asking first: Why the late-50s' switch?

The Great Depression, of course, was finally becoming faint memory, as was
its record of destroying stockholders while handing deflationary gains to fixed-income
bonds. Second, the idea of growth-stock investing - propounded by youngsters
like Peter Bernstein himself - was starting to take hold, slowly mutating into
the "cult of equity".

But a third (and more critical) change, however, was in the underlying promise
of return on versus return of your money. Because where risk-capital
was formerly known as "equity", government bonds were fast on their way to
becoming "certificates of confiscation" as the long post-war inflation took
hold. So you could even put the switch down to the slow death of that natural
deflation built into the Gold
Standard (or rather its step-nephew, the Gold Exchange system), starting
at the very same time as US stockholders kissed goodbye to earning a premium
each year above Treasury yields.

From that year - 1958 - until 1971, "There was not one year," says Texas professor Francis
Gavin, "when the Dollar and gold problem was not the most pressing issue
of American foreign economic policy." Because America was flooding the world
with Dollars, which the world in turn kept exchanging for gold, draining
Fort Knox until Richard Nixon closed the Fed teller's window and the US finally
abandoned its $35-per-ounce currency peg.

Lacking all gold-backing today, it's plain to see that the relationship between
stock and bond yields was snapped in half five decades ago. And whatever snapped
it is now at stake again.

So, two late-summer speculations for bargain-hungry investors:

#1. A few days or weeks won't do it. Last year's buy signal lasted
five months, knocking a further 20% off stocks before they turned higher. The
pre-1950s sell signal (then a near-zero or negative Div-Yield Premium) lasted
three months or so.

#2. Should this modern "buy" signal fail, it could fail with style, as
Tokyo bulls know only too well. Stock yields beat Japanese government
bond yields four times between late 1998 and end-2007. The first three worked
like a charm, but the fourth was a feint, with the Nikkei losing 52% over
the next 15 months, even as JGB yields fell still further below equity's
dividend yield.

That's an ugly warning, in short, from the "deflation nation" everyone fears
the US is aping. But to date, as the latest US housing, jobs and GDP data show,
printing money has only stalled the post-bubble deflation, not reversed it.

Formerly City correspondent for The Daily Reckoning in London and head of
editorial at the UK's leading financial advisory for private investors, Adrian
Ash is the head of research at BullionVault,
where you can buy gold
today vaulted in Zurich on $3 spreads and 0.8% dealing fees.

About BullionVault

BullionVault is the
secure, low-cost gold and silver exchange for private investors. It enables
you to buy and sell professional-grade bullion at live prices online, storing
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York and Zurich.

By February 2011, less than six years after launch, more than 21,000 people
from 97 countries used BullionVault,
owning well over 21 tonnes of physical gold (US$940m) and 140 tonnes of physical
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BullionVault is a
full member of professional trade body the London Bullion Market Association
(LBMA). Its innovative online platform was recognized in 2009 by the UK's prestigious
Queen's Awards for Enterprise. In June 2010, the gold industry's key market-development
body the World Gold Council (www.gold.org)
joined with the internet and technology fund Augmentum Capital, which is backed
by the London listed Rothschild Investment Trust (RIT Capital Partners), in
making an $18.8 million (£12.5m) investment in the business.

Please Note: This article is to inform your thinking, not lead it.
Only you can decide the best place for your money, and any decision you make
will put your money at risk. Information or data included here may have already
been overtaken by events - and must be verified elsewhere - should you choose
to act on it.